Chapter 15 The Role of Macroeconomic Policy

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Chapter 15The Role of Macroeconomic Policy
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Old and New Macroeconomic Policy Trade-offs (a)

• Old trade-off the Phillips curve
• Policy can lower unemployment but increase
  average inflation.
• If inflation is seen as very costly then policy
  actions will result in higher unemployment.
• If unemployment is seen as very costly then
  policy actions will result in higher inflation.
• In the 1970s a recognition that U sustained
• Unemployment returns to the natural rate in the
  long run.
• Choice is between lower or higher inflation in
  the long run.

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Old and New Macroeconomic Policy Trade-offs (b)

• New trade-off Output stability vs. Inflation
  stability
• John Taylor
• Attempts to stabilize output lead to greater
  fluctuations in inflation.
• Attempts to stabilize inflation lead to greater
  fluctuations in output.
• If policymakers focus too much on stabilizing
  inflation they get undesirable fluctuations in
  output and employment.
• Policymakers face a trade-off between stability
  in the real economy or inflation.
• Policymakers should focus on stabilizing the
  economy, and not on achieving a particular output
  or inflation outcome.

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Automatic Stabilizers (a)

• Fiscal policies changes in government purchases
  and taxes
• The most important automatic fiscal stabilizer is
  the income tax.
• When income increases, tax collections increase.
• Taxes tend to put limits on spending increases
  during a boom.
• This helps keep output closer to potential
  output.
• When income decreases, tax collections fall.
• This supports income and spending during
  downturns.

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Automatic Stabilizers (b)

• Transfer payments such as Social Security and
  welfare also function as automatic fiscal
  stabilizers.
• When income falls, these programs support
  household income, so consumption spending does
  not fall as much.
• These programs shrink when income rises.

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Automatic Stabilizers (c)

• Automatic stabilizers make the slope of the ADI
  curve steeper since they help dampen the
  fluctuations in output keeping output closer to
  potential than otherwise

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Automatic Stabilizers and the Government Budget

• Budget deficit government spending - net taxes
• Where net taxes taxes - transfers
• When income increases, taxes rise and transfers
  fall, so net taxes increase.
• This means the government budget deficit moves in
  the opposite direction of income
• The government budget deficit changes
  automatically with the economy.
• The government budget deficit is countercyclical.

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The Structural or Full-Employment Deficit

• The structural or full-employment deficit or
  surplus is the deficit or surplus that is
  independent of the business cycle.
• A government is fiscally responsible if the
  structural or full-employment deficit is zero.

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Discretionary Fiscal Policy

• Discretionary fiscal policy deliberate action by
  the government using taxing and spending programs
  to achieve its macroeconomic goals
• Represented by shifts in the ADI curve for a
  given level of inflation
• The Kennedy tax cut of 1964
• The tax surcharge for the Vietnam War
• Fiscal policy is not flexible or quick enough to
  react to short-run fluctuations.
• It takes longer than a year to be implemented and
  have an effect.
• Since WWII the average recession has lasted less
  than one year.
• By the time discretionary fiscal policy has an
  effect the problem may no longer exist.

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Using Discretionary Fiscal Policy to End a
Recession

• When government spending increases, the ADI curve
  shifts right.
• Output moves back to potential Yf.

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Monetary Policy (a)

• FOMC meets about every six weeks to decide on
  monetary policy.
• FOMC controls bank reserves to target federal
  funds rate
• Federal funds rate and prime interest rate move
  together
• The prime interest rate affects the cost of
  borrowing for firms and households.
• The nominal federal funds rate is now the main
  policy tool of U.S. monetary policy.

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Monetary Policy (b)
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The Monetary Policy Rule (a)

• The policy rule indicates how much the Fed should
  raise the real interest rate when inflation
  rises.
• To implement the rule, the Fed adjusts the total
  supply of reserves to achieve the appropriate
  federal funds rate.

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The Monetary Policy Rule (b)

• The federal funds rate is a nominal interest
  rate, i r ?.
• Suppose ? ? or the Fed expects ? to rise.
• The Fed reduces reserves so the increase in the
  nominal federal funds rate exceeds the increase
  in inflation.
• Di Dp 0 so Dr 0, which decreases aggregate
  spending

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The Monetary Policy Rule (c)
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Graphical Representation of the Monetary Policy
Rule

• If inflation rises, the Fed raises the real
  interest rate.
• The difference between the policy rule and the
  45-degree line is the real interest rate.

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The Fed Responds to Other Variables

• The Fed may also respond to
• Stability and growth of output
• Unemployment
• If unemployment rises, the Fed will lower real
  interest rates.
• In most cases it is consistent with the Fed's
  cutting rates when inflation falls since falling
  inflation is related to high unemployment.
• Expectations of future output and inflation
  changes
• For example in early 2001, the Fed cut the
  federal funds rate because it believed a
  recession was around the corner.

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Real Interest Rates and Nominal Interest Rates (a)

• If at full employment the government deficit
  increases, national savings falls, so rf rises.
• This is represented by a shift up of the policy
  rule curve.
• This is not an automatic action the central bank
  must decide to change nominal interest rates.
• In the past, failure by the Fed to adjust the
  nominal interest rate has resulted in poor
  economic performance.

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Real Interest Rates and Nominal Interest Rates (b)
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Fiscal Policy When the Feds Policy Rule Does Not
Adjust and When It Does
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Explicit Inflation Targets

• Many countries have explicit targets or ranges
  for inflation.
• The Bank of England targets inflation at 2.
• The Bank of New Zealand has a target range of
  03 inflation.
• The European Central Bank also has a range of
  02 inflation.
• The Fed has no explicit inflation target but, its
  actions are consistent with a 13 range for
  inflation.

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Changing the Inflation Target (a)

• Suppose the central bank wishes to lower the
  inflation target that is, lower the amount of
  inflation in the economy.
• To do so, it must first raise the nominal
  interest rate.
• This raises the real interest rate for a given
  rate of inflation.
• This means that to lower the inflation target,
  the policy rule curve must shift upward
  initially.
• Spending and output fall, unemployment rises, and
  wage and price inflation fall.

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Changing the Inflation Target (b)